You Got This Weekly Series: The Tax Implications of Investing in a Business

Question:

I invested enough to fund the expected expenses in my son’s golf business to cover 3 years as did one other investor. The account can be drawn from to cover travel, food, anything that promotes the business directly. We get paid a percentage of all income and that money goes into a different account that is paid out to the investors at the end of each year. The payback formula should allow us to recoup our investment plus some profit over the 3 years. Since we have given 3 years expected expenses up-front do we have the (total invested minus the income generated in the first year) as a loss in the first year and in the second year all income is profit since the initial investment is already written off?

Answer:

The majority of the tax implications of investing in a business depend on the structure of the business in which you are investing.

Generally there are two types of businesses – partnerships and corporations.

How and when you report any gain or loss, or report any income or expenses, depends on the structure of the business.

Partnership

If the business is set up as a partnership, and you are a partner in the business, the income and expenses pass through to your individual tax return.

The business will file an information return and send you a Schedule K-1 (Form 1065) reporting your share of the income and expenses. You will then report the Schedule K-1 (Form 1065) on your individual tax return.

Your basis in the partnership is the amount of your investment in property for tax purposes. The adjusted basis is used to figure your gain or loss on the sale or disposition of partnership interest.

Corporation

If the business is set up as a corporation, and you received stock in exchange for your cash investment, the corporation distributes the profits to you in the form of dividends.

The dividends are reported to you on Form 1099-DIV, which you must report on your tax return. You won’t recognize any gain or loss until you sell or exchange your stock in the business.

In either case, you need to keep track of your basis in this investment just like any other investment.

Your initial investment in the business is your starting basis in the investment. You then adjust your basis accordingly over the years based on any income, distributions or reinvestments.

If you receive a distribution from the business as a return of capital, that means you are being repaid for your initial investment in the business.

You then reduce your basis records by any return of capital distributions.

If you decide to sell your interest in the business, you will then calculate any gain or loss on your investment at the time of sale. You will use your basis in the investment compared to the sales proceeds you receive for selling your interest to determine any gain or loss.

If you receive a return of capital distribution that exceeds your basis in the business, then the excess is claimed as a capital gain.

Here’s an example:

Jason invests $5,000 in Business A.

In 2013, Jason receives a return of capital distribution for $3,000 in cash. In Jason’s records, he reduces his basis in the investment by $3,000, giving him an adjusted basis of $2,000. The $3,000 will not be included as income on his 2013 tax return.

In 2014, Jason sells his interest in the business for $6,000. Jason will claim a capital gain of $4,000 for this sale. This gain is calculated as sales proceeds ($6,000) minus Jason’s adjusted basis ($2,000).

Here’s another example:

Let’s say Jason decides not to sell his interest in the business in 2014.

In 2014, he receives another return of capital distribution for $3,500. At the time of the distribution, Jason’s basis in the investment is only $2,000. Therefore he will report a gain of $1,500 ($3,500 less $2,000) on his 2014 return.

Jason’s adjusted basis going forward will now be $0. Therefore any future return of capital distributions will be completely taxable as a gain.

When Jason sells his interest, the full sales proceeds amount will be considered capital gain because Jason’s adjusted basis in the business is $0.

Any current year income amounts that apply to you will be passed through on a Schedule K-1 issued to you by the business.

This form will report your share of any income from the year, which you’ll report on your tax return.

Depending on the business structure, these current year income figures may need to be factored into your basis as well.